Are Liar Loans Going to Get Principal Reductions?

Clifford Rossi

MAY 9, 2012 8:30am ET

The announcement by Bank of America (BAC) of their plan to offer up to 200,000 struggling homeowners a new lease on life for their underwater mortgage through principal reduction at first glance seems like a major step forward in addressing a nearly 5-year old problem.

Principal modifications are the mortgage industry’s third rail issue, fraught with passion on both sides of the debate over the merits of such programs. The attention given to FHFA Acting Director DeMarco’s seeming reluctance to allow the GSEs to deploy such measures is a case in point.

Many economists favor principal forgiveness over interest rate reduction or term extension modifications based on the idea that reducing principal will lower the likelihood that the borrower will redefault by lowering the negative equity position.

Moreover, some embattled lenders seem to have capitulated against federal and state mortgage legal actions by touting principal reductions that up to now were used only sparingly.

The real value of principal reduction comes down to determining the borrower’s behavior toward that program. For current but underwater borrowers, a concern that’s been levied and to this day remains unknown is the ruthlessness by which such borrowers, realizing that there may be an opportunity to receive a principal modification upon going 60 days delinquent, exercise their default option to obtain this lucrative debt elimination offer (often referred to as strategic default). Much depends on the friction costs such borrowers face in the form of damaged credit, relocation expense and other assorted costs.

As one can imagine, the value of that option depends on how much principal reduction the borrower might receive. In the Bank of America announcement, this could be as much as $150,000, certainly an amount that would make most people take notice. Bank of America has taken actions to forestall such attempts to allow strategic default by requiring all borrowers for principal reduction to pass a hardship test. That would eliminate those borrowers current on their mortgage but otherwise with motive (i.e., underwater) and intent to default. For eligible borrowers that are both delinquent and underwater, the prospect of principal reduction is conveyed in terms of net present value against alternatives. A primary determinant of whether a principal reduction modification is economically attractive over other modification alternatives is the borrower’s propensity to redefault on the new modified mortgage later.

The poor results of the government’s modification efforts provide some evidence that interest rate and term extension modifications have not worked, leaving the door open for more principal reductions. In option theory terms, a principal reduction modification reduces the option strike price, which lowers the attractiveness of defaulting in the future. But while lowering the borrower’s loan-to-value ratio to 100% from say 140% certainly helps lower that chance of redefault, it does not eliminate it and much depends on what’s going on inside the head of the borrower. And as it turns out, there is a large segment of the borrower population that is eligible for a principal reduction modification that may have already tipped their hand in terms of their intent to take advantage of such programs.

Lurking below the surface is an ugly and messy public policy problem – namely what to do about the group of delinquent and underwater borrowers who were not truthful with lenders regarding their ability to repay their contractual debt obligation. In the vernacular, so-called “liar loans” typified by the alphabet soup of products with such names as SISA (stated-income, stated-asset) and NINA (no income, no asset) blossomed during the housing boom. But what is interesting is the virtual silence on the millions of borrowers who consciously signed loan documents knowing that their income was overinflated well beyond justifiable levels. Quality control departments during the boom tracked these developments against actual IRS 4506 tax documents with common results showing that high percentages of these loans had overstated their incomes by at least 50%.

Now, to be sure, some coaching and documentation errors by lenders and mortgage brokers explain some part of this phenomenon, however, it cannot explain the majority of this problem. The Bank of America program does not disqualify such borrowers from receiving principal reductions and therein lays a terrible credit and public policy precedent. Beyond the fact that rewarding such borrowers that intentionally deceived lenders and security-holders by making false statements regarding their income and assets goes against principles of living by the golden rule, it exacerbates a troubling trend in borrower behavior that developed during the housing boom. That is, historical stigmas of excessive leverage and delinquency, which were powerful drivers of low mortgage delinquencies for decades, underwent a fundamental yet subtle transformation, exhibited by radical changes in borrower payment hierarchy and a higher incidence of personal bankruptcy observed in recent years as well as in other forms.

Anyone with a mortgage – delinquent or current that went through the effort to fully document their income and assets ought to be incensed over this policy and demand that no principal reduction program – private or public be permitted for borrowers who took out these more egregious form of low doc mortgages. It incents some borrowers to pursue strategies to game the system, and while great focus has been given the other direction; namely establishing policies to mitigate predatory consumer lending practices, lenders and policymakers must not reinforce behavior that also contributed to the collapse of the mortgage industry.

UDAP, Fair Lending Issues Causing CRA Downgrades

By Kate Davidson

MAY 8, 2012 4:27pm ET

WASHINGTON – With regulators increasingly cracking down on unfair and deceptive acts or practices, more banks are seeing the heightened scrutiny reflected in lower Community Reinvestment Act ratings.

That trend is likely to increase now that the Consumer Financial Protection Bureau has joined the team, industry observers say. Although the bureau does not have authority to enforce CRA, it has a broad mandate to root out fair lending violations, and plans to coordinate closely with the prudential regulators to ensure those findings are factored into CRA ratings.

“We’ve had a downward trend for a while,” Jo Ann Barefoot, a co-chairman of Treliant Risk Advisors, said of CRA ratings. “But the fact that UDAP is now being brought more proactively into the CRA evaluation process does mean that there will be an increasing impact on CRA by what the bureau does with UDAP.”

Regulators have been handing out harsher CRA ratings since the financial crisis began. While many of those downgrades could arguably be linked to the crisis – with banks focusing more on problem loans than lending in underserved communities – recent results indicate a strong link with UDAP.

Of the 28 banks whose ratings were released by the Office of the Comptroller of the Currency last month, for example, five had their ratings lowered to “Needs to Improve,” and three were downgraded specifically for illegal credit practices or discrimination relating to UDAP and fair lending violations.

The OCC said it found “substantive” violations of the Equal Credit Opportunity Act and Fair Housing Act that represented a “pattern or practice” of discrimination at the First National Bank of St. Louis in Clayton, Mo.

It also found unfair and deceptive acts or practices relating to the overdraft protection program at Woodforest National Bank in The Woodlands, Texas, as well as illegal credit practices in violation of the Federal Trade Commission Act at BankAtlantic in Fort Lauderdale, Fla. (BBX)

The percentage of banks receiving failing CRA ratings – including needs to improve and substantial noncompliance – has increased from 1.7% in 2007, to 4.3% as of March 31, according to data from CRAHandbook.com.

“It’s a combination of regulators getting tougher, but the broadening of the CRA net to include fair lending, UDAP, and other issues has also contributed to the lower ratings,” said Ken Thomas, an independent bank consultant and economist based in Miami.

All of the violations identified by the OCC were uncovered during CRA compliance exams, which occur about every three years.

But with the CFPB regularly supervising large banks for compliance with consumer financial laws, the bureau is likely to soon be the one finding these violations.

Information sharing will be critical, said Ann Jaedicke, a managing director at Promontory Financial Group and a former deputy comptroller for compliance policy at the OCC.

“The prudential regulators may have a finding of their own with respect to illegal credit practices or discrimination,” Jaedicke said, “but because the predominant regulations around those issues have been transferred to the CFPB, the CFPB will actually be doing examinations that would disclose those kinds of illegal credit practices or discrimination.

“There is going to have to be sharing of information so that the prudential regulators can factor the CFPB’s findings into their ratings,” Jaedicke said.

Patrice Ficklin, the CFPB’s assistant director for the Office of Fair Lending and Equal Opportunity, acknowledged the need for cooperation in a panel discussion at a conference of housing advocates in Washington last month.

Ficklin noted that CFPB only inherited two of the four federal fair lending laws: the Equal Credit Opportunity Act and the Home Mortgage Disclosure Act. The prudential regulators will continue to enforce CRA and the Fair Housing Act.

“Because of the split among the four federal fair lending laws, we have a significant obligation and interest in coordinating with our sister regulators,” Ficklin said.

For example, Ficklin said CFPB knows that both the Fair Housing Act and the Equal Credit Opportunity Act govern real estate related lending, and that the bureau’s fair lending exams will factor into CRA ratings.

“So the need for coordination is already recognized and well under way with regard to our interactions . . . with our fellow prudential regulators,” she said.

Because the fair lending issues are so intertwined, industry observers are waiting for more specific information, including clear protocols, on how the bureau intends to cooperate with other regulators.

The agencies have been working on a formal memorandum of understanding, expected to be released in the coming weeks, that would outline such procedures.

Barefoot said the intersection of fair lending issues makes it more likely that banks will be scrutinized, possibly by several different agencies for the same practice.

“One thing I’ve been hearing from the regulators is that a lot of times they get a UDAP issue and explore it, and when they look at who was most impacted by the UDAP issue, it’s a protected class,” she said. “So it’s also a fair lending issue. They refer it to the Justice Department, and in the meantime downgrade the CRA rating.

“It can start in any direction and fill up the whole space – fair lending, CRA and UDAP,” Barefoot added.

That means a higher likelihood of CRA downgrades based on those issues, industry observers agreed. The adverse ratings, of course, would cripple a bank’s ability to make acquisitions or merge with another institution.

“If I were an executive at a financial institution I would be talking with my CRA officer about what he or she thinks the forthcoming CRA rating might be and whether or not they’re concerned about it at all,” Jaedicke said. “The other thing banks can do is make sure they scour their portfolio to capture every possible lending relationship that might qualify for CRA credit.”

Obama, Donovan Challenge Republicans on Mortgage Refinancing

By Kevin Wack

MAY 8, 2012 5:21pm ET

WASHINGTON – The Obama administration used a speech by the president and an appearance on Capitol Hill by his housing secretary Tuesday to launch a push for legislation that would allow more Americans to refinance into lower interest rate mortgages.

The new legislative effort met immediate resistance from Republicans on the Senate Banking Committee, who complained that Democrats may ruin a chance at forging bipartisan legislation by bypassing a committee vote on the matter.

President Obama, using a speech in Albany, N.Y., to unveil what he called a job-creation to-do list for Congress, pressured Republicans to support the refinancing plan as one of the five ideas on the list.

“This would make a huge difference for the economy. Families could save thousands of dollars, and that means they’ve got more money in their pocket,” Obama said. “We estimate they’d save at least $3,000 a year. So that’s on our to-do list. It’s not complicated.”

In Washington, Housing and Urban Development Secretary Shaun Donovan told the Senate Banking Committee that now is the time to pass three refinancing bills, which would benefit different groups of homeowners.

“There is a real urgency here because interest rates today are at the lowest level they’ve ever been for a 30-year mortgage,” Donovan said. “But as the economy continues to improve, I think all expectations are that this window of record-low interest rates may not last a significant period of time. And therefore, it is particularly urgent that we take advantage of this.”

But none of the three proposals have even been introduced as bills yet.

On the first proposal, the Obama administration has been working with Democratic Sen. Dianne Feinstein on a measure that would allow homeowners whose mortgages are not owned by Fannie Mae or Freddie Mac to refinance into a government-backed loan.

Obama originally rolled out this idea during the State of the Union address, and he proposed paying for it with a fee on the largest financial institutions, but that idea garnered little support in Congress. Donovan has said more recently that the administration is open to other ideas for covering the estimated cost of up to $5 billion, but he made clear Tuesday that the issue has not yet been resolved.

Donovan’s testimony did include some new details about the proposal. He stated that the Federal Housing Administration, which would operate the program, would establish a second insurance fund, separate from its existing mortgage insurance fund, to better track and manage the risk that results from the new program.

The HUD secretary also announced that mortgages that are worth 40% more than the value of the home will not be eligible for the program.

“Lenders interested in refinancing deeply underwater loans would therefore need to write down the balance of these loans before they would qualify,” he said in written testimony.

The second proposal, which is being developed by Democratic Sens. Robert Menendez and Barbara Boxer, may be easier to sell on Capitol Hill because it does not require the federal government to take on any additional exposure to the mortgage market.

The proposal, which according to Menendez will be introduced as a bill in the next few days, would remove certain existing barriers to refinancing for homeowners whose loans are already backed by Fannie or Freddie. For example, it would allow new servicers to use the same streamlined underwriting process that servicers of existing mortgages are already using under an existing administration refinancing program.

“What we’re seeing in a lot of cases is that because there’s essentially a monopoly on refinancing, whoever holds their current loan, whoever is the servicer, they can charge them, and we’re seeing this, very high fees,” Donovan said.

A third refinancing bill, which had not previously been announced, would provide a financial incentive for borrowers to rebuild equity in their homes by taking out a shorter-term loan when they refinance. That measure is expected to be introduced by Democratic Sen. Jeff Merkley.

Homeowners who qualify for the program would have their closing costs covered, for an average savings of $3,000, according to administration estimate.

The fate of the Democratic refinancing proposals will rest with Republicans in both the House and Senate, and they got off to a rocky start with the GOP on Tuesday.

Republican Sens. Richard Shelby and Bob Corker warned during Tuesday’s hearing that any attempt to bypass the Senate Banking Committee will not be received well by the GOP.

“I’m hearing rumors that some of these bills may go straight to the floor and not come through the committee,” Corker said. “I hope that the chairman will not let the rumors that we’re hearing become reality.”

Shelby agreed: “The committee is the best forum – I believe, right here – to facilitate careful deliberations and the needed compromises. In contrast, bypassing the committee and proceeding directly to the floor with any legislation will almost certainly result in partisan gridlock.”

Following Tuesday’s hearing, Banking Committee Chairman Tim Johnson declined to comment on his plans for moving the refinancing bills. “I have not talked to the leadership about this issue,” he said.

The proposal to refinance privately owned mortgages into government-backed loans appears to face the toughest fight with Republicans, who object to expanding the government’s exposure to the mortgage market.

But at Tuesday’s hearing, GOP senators indicated that they are also not happy with the way that Democrats are proposing to deal with the impediment to refinancing posed by second liens.

“Candidly, shouldn’t the second lien automatically be extinguished first, period, gone?” Corker said. “Why would we give any credit at all to a second lien when you’re writing down any portion, even a penny, of the first lien?”

Competition Fierce, Profits Ample for Harp 2.0 Refis: Fifth Third

By Kate Berry

MAY 8, 2012 2:01pm ET

Competition is heating up among banks in the government’s revised Home Affordable Refinance Program, which has helped spark a refi boom and contributed to strong mortgage profits at most banks.

“We’ve been pretty aggressive” with direct mail solicitations and newspaper ads, says Bob Lewis, a senior vice president and the head of mortgage lending at Fifth Third Mortgage. His loan officers also are combing through files and encouraging past customers to refinance if they haven’t already.

The unit of $117 billion-asset Fifth Third Bancorp (FITB) in Cincinnati was the sixth-largest Harp lender in the first quarter. Refinancings through Harp 2.0 now make up 49% of the bank’s total refinancing volume, Lewis says.

The bank’s first quarter originations resulted in gains of $174 million on mortgages sold to Fannie and Freddie, a 180% increase from gains of $62 million in the first quarter a year earlier.

Lenders were given plenty of sweeteners to participate in Harp 2.0, and critics have argued that rather than offering the lowest interest rates possible, these lenders are raking in outsized profits.

Lewis says the program has been quite profitable for lenders, but that this reflects the vagaries of the market.

“Everybody’s stealing it,” Lewis says, referring to gain on sale margins. “Several things go into that activity. Rates have moved around over the last six months, in a 50 basis point range, and that can create opportunities when you’re selling to the secondary market.”

The purpose of Harp 2.0 was to expand access to refinancing so underwater borrowers with loan-to-value ratios greater than 125% could take advantage of low interest rates and lower their monthly mortgage payments, reducing the potential for strategic defaults.

Still, Lewis framed the issue as one in which banks are simply doing their part to aid the housing recovery.

“We see it as an opportunity to help the communities in our footprint and help consumers maintain homeownership in a challenging environment,” he says. “I don’t know if it’s helping the housing market recover but if borrowers get more affordable payments, there will be fewer foreclosures and the glut of inventory on the market will decline.”

Volume of Harp 2.0 refinancings has been so high that some large lenders, lacking capacity to handle so many requests, are tightening underwriting just to keep from being inundated. For example, Wells Fargo (WFC) has capped loan-to-value ratios at 105% for loans it does not service itself.

Fifth Third is bucking that trend. It accepts borrowers with LTVs as high as 150% LTVs – and may go even higher.

“We’re confident at 150%,” says Lewis. “We selected 150% as a starting point and will evaluate this continually and explore it going forward.”

Lenders are in stiff competition for refinancing largely because the revised program removed the liability for buyback requests from Fannie and Freddie. Borrowers also are not required to get a new appraisal on their home, a major impediment to past attempts to aid consumers who owed more on their mortgage than their home is worth. Also, lenders are required to verify employment only on refis of loans they already service.

Lewis called the release from liability for repurchases “really huge,” though he admits there are “challenges” for lenders that refinance loans currently held by another servicer. Still he thinks refis could remain strong over the life of the program, which was extended through next year.

He also praised the revised program for allowing borrowers to transfer private mortgage insurance policies from one lender to another.

“We were an aggressive Harp lender, we worked out our own portfolio pretty well and so one of our bigger opportunities is going to be with the open access because borrowers can choose the lender they want to deal with,” Lewis says.

Fifth Third’s mortgage banking revenue doubled in the first quarter to $204 million from a year earlier. Mortgage originations jumped 64% to $6.4 billion.

Lenders “have built big pipelines, including us, and baring any economic or world-changing activity, rates could stay down for a while,” Lewis says.

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